Russia Will Always Be Cheap

That's how Winston Churchill characterized Russia 60 years ago. Little about its mystique has changed. For Churchill, the mystery could only be understood through the prism of national interests. Perhaps that would explain some of the Russian government's more recent moves on the economic front -- and their impact in keeping prices of Russian stocks extremely low, compared to companies in other emerging-market countries.

Foreign buyers bewareRussia's adoption of capitalism hasn't come without a dose of xenophobia. The government is clearly hostile toward the notion of foreign investors holding significant stakes in Russian companies or major projects. In one well-publicized example, ExxonMobil (NYSE: XOM) sought to take a 40% stake in former Russian oil giant Yukos. Upon learning of the possible deal, then-President Putin quickly devised a strategy to neutralize it -- by ordering the arrest of Yukos CEO Michail Khodurkovsky on tax-evasion charges just weeks after the Exxon news broke. Later, Yukos went bankrupt as its main subsidiary was auctioned off to help pay its back taxes, leaving Exxon out in the cold.

BP (NYSE: BP) was met with similar hostility. The Russian government arrested executives and raided the offices of its TNK-BP joint venture, in which BP had a majority stake. Royal Dutch Shell (NYSE: RDS-A) , too, had to give up a majority stake in the Sakhalin II energy project under pressure from Moscow.

The smart wayI could keep going, but all the cases are eerily similar -- majority stakes are not popular with Russian politicians. There is, however, far less concern about minority stakes. ConocoPhillips (NYSE: COP) was eager to buy a stake in Lukoil, which ultimately rose to 20%. Lukoil owns the world's second-largest hydrocarbon reserves held by a publicly traded company. (No. 1, of course, is Russian rival Gazprom.)

Lukoil is different than most Russian companies, because its share capital is composed primarily of minority shareholders. You have probably heard of the Russian "oligarchs" who control most leading Russian companies. But while company president Vagit Aleperov and vice president Leonid Fedun collectively control 30% of the company, their lack of a controlling stake makes Lukoil unique among major Russian businesses.

Through its ownership of ConocoPhillips stock, even Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) has a stake in Lukoil's growth. Growing reserves has been a big problem for multinational oil companies, leading them to pursue footholds in Russia. Clearly, the majority-stake concept will not work in that part of the world, but ConocoPhillips seems to be onto something.

Regional issuesUnlike Lukoil, Gazprom is majority-owned by the Russian government. Back in January, I highlighted Gazprom as the safest stock to own in Eastern Europe. That was half-hearted praise of the stock, though. As I mentioned in that January column, Eastern Europe is in a very precarious situation.

As a major commodity-driven economy, Russia is different from most of its eastern neighbors. Any recovery in the natural resource markets bodes well for the Russian stock market, and even the Russian ruble, but trouble in the region will still likely affect Russia's prospects.

The rest of Eastern Europe remains a giant powder keg, with a fuse close to running out. Although most news of the global recession has focused on the developing world, Eastern Europe also went through a speculative building boom, similar in some ways to what we saw in the U.S. As that boom unwinds, bank failures and currency devaluations could easily occur. The result could mirror what happened in Southeast Asia during the 1997 currency crisis there.

Political issuesEastern Europe's problems don't bode well for Russia, even though the country's treasury coffers are in somewhat better shape. Still, the main issue remains the hostility toward foreign capital. The country is suffering from the myopic nature of the Russian leadership.

Russia did not want foreign capital when oil was on its way to $145 a barrel. Now, though, when Russia needs foreign capital, it'll be a lot more difficult to get it.

That problem also extends to Russian banks. As much as 10% of the loan portfolio of OAO Sberbank, the largest bank in the country, could go bad, according to Merrill Lynch's Moscow-based economist. A third of its foreign reserves have been drained by the flight of capital out of the country, even though they remain high by Eastern European standards, at around $385 billion as of the end of March.

As an Eastern European myself, it gives me no pleasure to say that Russia remains a country with a lot of potential unlikely to be completely realized, because of the nature of its political environment. Russian authoritarian politics should have remained in the 20th century. Regrettably, they did not.

Unless the Russian government learns that lesson, the country's stocks will always be cheap.

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